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Home | Articles | A Choice of Tax Treatments for TSP Participants

A Choice of Tax Treatments for TSP Participants
December 18, 2012
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The Thrift Savings Plan (TSP) offers you two tax treatments for your employee contributions when you make a contribution election:

1. Traditional TSP -- If you make traditional contributions, you defer paying taxes on your contributions and their earnings until you withdraw them. If you are a uniformed services member making tax-exempt contributions, your contributions will be tax-free; only your earnings will be subject to tax at withdrawal.

2. Roth TSP -- If you make Roth contributions, you pay taxes on your contributions as you are making them (unless you are making tax-exempt contributions from combat pay) and get your earnings tax-free at withdrawal, as long as you meet the requirements to qualify.

Traditional TSP and Roth TSP

The Thrift Savings Plan began accepting Roth TSP employee contributions in May 2012. All employee contributions made before May 2012 are considered traitional contributions. When a participant is automatically enrolled in the TSP, he or she begins by making traditional contributions. If you want to make Roth contributions, you have to submit a contribution election to tell your agency what portion of your contributions you want designated as Roth.

*If you are a member of the uniformed services receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclu- sion), your contributions from that pay will also be tax-exempt.
   *If you are a member of the uniformed services receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclu- sion), your contributions from that pay will also be tax-exempt.

Traditional (pre-tax) contributions are taken out of your paycheck before your income is taxed. This lowers your current taxable income and gives you a tax break today. If you are a FERS employee, your agency's contributions also go into your traditional balance. This money grows in your account tax-deferred, but when you withdraw your money, you pay taxes on both the contributions and their earnings.

Roth (after-tax) contributions are taken out of your paycheck after your income is taxed. When you with¬draw funds from your Roth balance, you will receive your Roth contributions tax-free, since you already paid taxes on these contributions. In addition, you will not have to pay taxes on the earnings, as long as 5 years have passed since January 1 of the calendar year when you made your first Roth TSP contribution (known as the 5-year rule) AND you are at least age 59 1/2, permanently disabled (or deceased). If you satisfy these Internal Revenue Code (IRC) requirements, your earnings will be considered "qualified," and you will not pay any taxes on them at withdrawal.

Note: The TSP cannot certify to the IRS that you meet the IRC's definition of disability when your taxes are reported. You must provide the justification to the IRS when you file your taxes.

Tax-exempt contributions are contributions uni-formed service members may make while earning tax-exempt pay in a combat zone. If your tax-exempt contributions are designated as traditional contributions, you will pay no tax on the contributions, but your earnings will be taxed when withdrawn. If your contributions are designated as Roth, you will pay no taxes on your contributions, and their earnings will also be tax-free when withdrawn, as long as you meet the IRC requirements detailed in "Roth (after-tax) contributions" on this page.

Traditional and Roth balances. If you make an election to choose Roth contributions, your account will then be made up of two separate balances--traditional and Roth. These two "pots" of money will keep your contributions and any money you transfer into (or out of) your TSP account separate for tax purposes, but any loans, withdrawals, and interfund transfers you make will include a proportional amount from each balance. You will not be able to take out, borrow from, or change the investment of, just one pot of money.

Traditional Contributions vs. Roth Contributions: An Example of the Effect on Your Current Income

When you make traditional pre-tax contributions, you get two immediate tax advantages: Your actual TSP contribution is not taxed (it's tax-deferred until you withdraw) AND the money you contribute is taken out of your pay before Federal (and in most cases state) income taxes are calculated. As a result, the amount of pay used to calculate your taxes is reduced, so less money is with¬held from your pay for taxes.

When you make Roth contributions, assuming you con¬tribute the same percentage or amount of your pay to the TSP as you contribute in traditional contributions, more money will come out of your annual take-home pay.

Example:

Based on a participant filing singly -- with one personal exemption and standard deductions.
   Based on a participant filing singly -- with one personal exemption and standard deductions.

The difference: If you made traditional pre-tax contributions, you would have $308 more in your pocket in the current year than if you made Roth contributions.

Traditional Contributions vs. Roth Contributions: An Example of the Effect on Your Long-Term Savings

Choosing between traditional and Roth contributions comes down to whether you would be better off paying taxes on your contributions now or later; in other words, your marginal tax rate now versus your rate at retirement. Your personal situation will determine whether it is better to have the tax savings of traditional contributions now or the tax-free earnings of Roth contributions later.

To demonstrate this tax principle, suppose in one year you could afford to give up $4,000 of your income for retirement savings in the TSP, and you are in the 25% tax bracket. You could put $4,000 (traditional pre-tax), or $3,000 (Roth after-tax) into your TSP account. (The $4,000 that comes out of your paycheck to make Roth contributions = $3,000 in contributions + $1,000 in Federal income taxes.) The chart below compares the value after 10 years (at 6% annual rate of return) of this one-year $4,000 paycheck deduction after taxes, taking into consideration a lesser, equal, or greater marginal tax rate at retirement.


  

Generally, traditional contributions are to your advantage if your tax rate will be lower in retirement. Roth contributions are to your advantage if your tax rate will be higher in retirement. If your income tax rate is the same in retire¬ment as when you made the contributions, you'll end up with the same amount in your account whether you make Roth or traditional contributions.

The Contribution Decision Wizard on the TSP website (https://www.tsp.gov/planningtools/contributioncomparison/contributioncomparison.shtml) allows you to input information about your own situation and compare the effects of making traditional and Roth contributions on your long-term savings (as well as your paycheck). Visit the Contribution Decision Wizard to see whether making Roth contributions could be to your advantage. You should also consult a qualified tax advisor or financial advisor. Remember to reassess your decision any time your tax, income, or personal situation changes.

Tax Liability

When you withdraw your money from the TSP, you will owe taxes on any traditional contributions (except contributions made from tax-exempt pay), and the earn¬ings they have accrued. You can continue to defer these taxes by transferring or rolling over your TSP withdrawal payment to a traditional individual retirement account (IRA) or an eligible employer plan. You can also transfer or roll over your traditional funds to a Roth IRA, but you will have to pay taxes on the full amount in the year of the transfer.

If you have Roth contributions in your account, you have already paid taxes on them. You will not owe any further taxes on your Roth contributions, and you will not owe taxes on their earnings if your withdrawal pay¬ment is a "qualified distribution." In other words, if 5 years have passed since January 1 of the calendar year when you made your first Roth contribution and you have reached age 59 1/2, or have a permanent disability, the entire Roth portion of your account will be paid out tax-free. If your earnings are not qualified, you can defer paying taxes on them by transferring your payment to a Roth IRA or Roth account maintained by an eligible employer plan.

Retirement age and the penalty tax. If you receive a TSP withdrawal payment before you reach age 591/2, you may have to pay a 10% early withdrawal penalty tax on any taxable part of the distribution not transferred or rolled over. This penalty tax is in addition to the regular income tax you owe, but there are exceptions. In general, if you leave Federal service in the year you turn age 55 or older, the 10% penalty tax does not apply to any withdrawal you make that year or later.

In addition, disability retirement approved by the Office of Personnel Management may not exempt you from the early withdrawal penalty tax. The IRS requirement is more stringent, and you will have to substantiate your claim of exemption with the IRS. There are other exceptions to the early withdrawal penalty tax. See the tax notice "Important Tax Information About Payments From Your TSP Account," which is available from the TSP website, your agency or service, or the TSP. The tax rules that apply to distributions from the TSP are complex, and you may also want to consult with a tax advisor or the IRS before you make any withdrawal decisions.

Retirement Savings Contributions Credit. You may be able to take a tax credit of up to $1,000 (up to $2,000 if filing jointly) for your TSP contributions. Eligibility depends on the amount of your modified adjusted gross income (AGI). For tax year 2012, your AGI must be no more than $57,500 if married filing jointly, $43,125 if head of household, or $28,750 if single, married filing separately, or qualifying widow(er). (These amounts are adjusted each year for inflation. For more information, see your tax advisor or refer to IRS Form 8880.)

Source: TSP [TSPBK08 (5/2012)]